jan. 2015 global economics & caital market ......2015/01/01 · charts 9-10. the positive...

GLOBAL ECONOMICS & CAPITAL MARKET COMMENTARY

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The information contained herein, including any expression of opinion, has been obtained from, or is based upon, sources believed to be reliable, but is not guaranteed as to accuracy or completeness. This is not intended to be an offer to buy or sell or a solicitation of an offer to buy or sell the securities, if any referred to herein.

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Jan. 2015

OverviewIn last month’s commentary we described six key indicators which we believe serve as leading indicators for the US economy and for US equities. This month’s commentary will review those indicators that have, in the interim, made a significant change. Additionally we will review the positive and negative impact that the collapse in oil prices since October 1st will have on economies, markets and, most importantly, industries.

One of the key indicators reviewed last month that could potentially impact corporate margins adversely; boost inflation; and, possi-bly draw the Fed into a more negative policy mode than currently assumed would be a rapid rise in wage growth. Since our last report we have had an unexpectedly strong monthly payroll reading for October, Chart #1. This was accompanied by no change in the unemployment rate at 5.8% but the U6 rate did continue to decline.

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www.winslowevanscrocker.com ::: [email protected] ::: (800) 556-8600

GLOBAL ECONOMIC COMMENTARY JAN. 2015

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CHARTS 2 - 3. Although the U6 rate declined it remains well above peak levels of prior growth cycles and indicates that there remains considerable labor slack in the economy. Chart #2 shows that the growth rate for wages below the critical 3% threshold that would trigger the concerns mentioned above. Summary: October has seen a strong uptick in employment without experiencing the risk of runaway wage inflation. Indicators #2 and #3 mentioned last month have changed very little. The Yield Curve, indica-tor #2, has flattened a little but remains positive while the capitalized value of the National Income Profits Account (NIPA) using the BAA yield has not changed at all. Once again, this is not an indication of a weaken-ing economy. A fourth indicator is the Conference Board’s Consumer Sentiment Survey Present Situations Index, Chart #3. Much like the capitalized NIPA indicator mentioned above this indicator will also peak and roll over about four months prior to the onset of a recession. As can be seen in Chart #3 this indicator leapt by over 5% in December. This rapid improve-ment was likely influenced by declining gasoline prices; the strengthening jobs market; and, the continued rise in the equity markets.

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CHART 4. The fifth indicator, the unemployment rate, remained unchanged last month. The sixth indicator, the spread of high yield debt yields over the 10 year US Treasury yield has been trending up since mid-year and recently spiked up sharply only to quickly narrow once again, Chart #4, blue line. Since oil and gas companies now constitute ~19% of the high yield index it is no surprise that spreads have widened as oil prices have collapsed. Whether or not this constitutes a poten-tial systemic problem needs to be answered by looking at another indicator, the 2 Year Swap Spread which is indicated in green on the same chart. Notice that this spread did not follow the high yield spread and, for now, is trending down. This is indicating that any negative fallout from lower oil prices will likely be contained within the industry and not become a sys-temic problem for the economy.

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CHARTS 5 - 6. This, of course, leads us to our second topic of discussion: the positive and negative impact of the collapse in oil prices:

The Positives

The Impact on Lower Oil Prices Has Been Underestimated: The fall in oil prices is particularly helpful to low-end consumers who have seen the largest real decline in wages since the end of the recession. Because of their low savings ratio the wind-fall gain from lower gas prices will likely be spent. As shown in Chart #5 where we have calculated the energy costs as a percentage of Personal Consumption Expenditures (PCE) against retail spending it is clear that there is a very high correlation (R2=.75) with declin-ing energy costs. The blue line in this chart is inverted and represents the % that energy constitutes PCE while the red line represents the annual change in retail sales. As shown in Chart #6 this fits nicely with our theme of overweighting consumer discretionary stocks which, as shown by their rela-tive performance (red line) to the S&P500, troughed in early October and are now showing strong improvement due, in part, to lower energy costs.

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CHART 7-8. Negative For Inflation Expectations:In the near term the sharp fall in oil prices will likely be disinflationary with the IMF suggesting that it could take nearly 1.0% off of inflation in the developed world over the next year. This could be even greater as those industries that rely on commodity inputs experience a drop in costs in combination with a decline in pricing power. This is reflected in the recent collapse in the 5 year inflation expecta-tions for the US and Europe shown in Chart #7. In the medium term this may become inflationary as central banks in the Eurozone, Japan and China remain proactive (Chart #8) while, at the same time, lower oil prices stimulate growth.

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CHARTS 9-10. The Positive Impact on Equities:During the mid-1980’s when oil prices fell by ~70% the S&P500 gained a little over 50%. In Chart #9 it can be seen that by mid-1986 oil prices as represented by the blue line, inverted, had declined by over 60% from October of 1985 while the S&P500 peaked the following year at +80 for the same time period. Although the market succumbed to the 1987 “Black Monday” crash it soon resumed its upward trend to finish the decade at ~+90% while, over the same time period, oil fin-ished at down ~-40%. Also, as mentioned above, the declin-ing inflation expectations is allowing most major central banks to pursue easy monetary policies which will have a posi-tive impact on global excess liquidity and thus equity valu-ations as shown in Chart #10. Other areas that will benefit significantly from the fall in oil prices are primarily the oil importers. The Euroarea, for example, is forecasted to expe-rience at least a 0.5% benefit to GDP growth and, with the associated lower inflation expectations, more flexibility for the ECB to pur-sue expansionary monetary policy. Like the US, European Consumer Discretionary spending sectors should benefit. Other major energy importers such as India, Japan and South Korea should also benefit. In addition to geographical beneficiaries, industries that have high energy input costs but can maintain pricing power will experience expanding mar-gins and equity valuations.

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The Negatives

The impact of falling oil prices will be particularly negative on countries with current account deficits and that are commodity exporters. Looking at commodities is instructive because their prices are likely to fall in response to falling oil prices (as this reduces the cost of producing commodities). Indo-nesia, Brazil and Mexico fall into this category. Russia, although running a current account surplus, will soon be running a deficit and, combined with capital flight, will begin to experience an economic contraction. A collapse in Russian domestic demand puts at risk companies with high Russian expo-sure in addition to countries, such as Finland, that have a significant portion of their GDP tied to the Russian economy.

Within the US equity markets the industries that will likely suffer the most are the Oil & Gas Service sector, Exploration & Development Companies and commodity royalty trusts and upstream MLPs.



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CHARTS 11-14. The Oil&Gas service sector will likely face strong headwinds as exploration and pro-duction companies begin cutting back on capital expenditures and it is a sector we recommend un-derweighting. Chart #11 illustrates the recent collapse of the O&G Service sector in sympathy with oil prices. Although the R2 since 2009 has been around .45 it appears to have tightened to nearly 1.0 since mid-2014. The more telling correlation is between the E&P company capital expenditures and the O&G services sector where the R2 = ~.78 as shown in Chart #12. Forecasts for 2015 capital expenditures are for a decline of ~15%. This coupled with pressures to lower costs and increase effi-ciencies is already resulting in dramatically lowered forward earnings estimates for the industry, Chart #13. The risks, we believe, are to the downside as evidenced in Chart #14 where we have calculated the capital expenditures of the E&P companies as a percentage of market value.

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CHART 15. It is currently at a record high which may be due in part to the decline in the market value of the sector but certainly illustrates that capex could certainly fall further than current forecasts. Per-haps the only redeeming data that can be taken from this chart is that the forward P/E of the O&G sector is below levels when oil was under $40/bbl. Another concern is the timing of when oil prices and demand will fall into equilibrium. Last month the International Energy Association (IEA) lowered their global oil demand forecast for 2015 by 0.9 million bbl/day, as shown on Chart #15.

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CHARTS 16-17. In this report we have discussed the areas of conviction we have of the winners and losers resulting from this dramatic decline in oil prices. As a last observation we would like to comment that the Oil & Gas Pipeline group has suffered uncharacteristically high levels of volatility this year, Charts #16 and #17, after hav-ing outperformed both the price of oil and the S&P500 since the end of the recession. Year to date the index has slightly outperformed the S&P500, Chart #17. The index consists of upstream MLP’s which would indeed be adversely impacted by the precipitous fall in oil prices. Additionally, hedge funds and other short term or margined institutional investors were very likely sellers as oil declined and, because the MLP sector has a relatively small market capitalization any major selling will tend to cause major price swings. It has long been our position to stay focused on the midstream pipeline sec-tor and to look for events like those of the past few months as a buying opportunity for the appropriate portfolios.

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CHART 18. The group’s yield over BAA bonds now stands around one standard deviation above its 10 year mean and well above levels warranted by the St. Louis Financial Stress Index, Chart #18.

In conclusion, we have reviewed our six leading indicators for the US economy and have found two that have improved significantly: Non-Farm Payrolls and Consumer Confidence. The only negative observed was the spike in High Yield Spreads but that wasn’t accompanied by an equal rise in the 2 Year Swap Spreads which, if it had, would have been an indicator of concern for systemic issues. These indicators have since settled back down. The collapse in oil prices will likely have a net positive impact on global GDP growth of at least an additional 1.0%. The winners and losers are broadly spread around the globe but, for our purposes, we emphasize the benefit to the Consumer Discretionary sec-tor for overweight and the Oil & Gas Services Sector for an underweight. Finally, we observed that the classic “baby with the bathwater” phenomenon occurred with the MLP pipeline sector and have emphasized that it has provided a buying opportunity for the appropriate portfolios.

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jan. 2015 global economics & caital market ......2015/01/01 · charts 9-10. the positive...

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